European Banks Get ‘False Deleveraging’ in Seller-Financed Deals

Royal Bank of Scotland Group Plc, which got a 45.5 billion-pound taxpayer bailout in 2008, said in July that NewYork-based Blackstone would find outside financing to buy part of a 1.4 billion-pound U.K. commercial-property loan portfolio codenamed “Project Isobel.” Photographer: Chris Ratcliffe/Bloomberg

Royal Bank of Scotland Group Plc may provide as much as 600
million pounds ($939 million) in debt to help Blackstone Group
LP acquire part of a 1.4 billion-pound portfolio of commercial
mortgages from the bank after the private-equity firm struggled
to get outside funding, three people with knowledge of the
transaction said. The deal, scheduled to close within weeks,
follows Credit Suisse Group AG’s agreement to finance the sale
of $2.8 billion of property loans to Apollo Global Management
LLC in December, two people with knowledge of the matter said.

“The use of vendor financing to de-lever defeats its own
purpose,” said David Thesmar, a professor of finance at HEC
Paris, a business school. “The assets may become safer because
the buyer injects equity, but the actual gain in core Tier 1
capital ratio for the bank isn’t as great as if it was purely
and simply sold. It shows banks’ deleveraging is going to be
tougher than planned.”

The increase in vendor financing reflects the challenge
European banks face selling their distressed loans and avoiding
greater losses as the sovereign-debt crisis deepens. Lenders
have pledged to cut assets by more than 775 billion euros ($1.05
trillion) within two years as regulators require them to meet a
9 percent core capital ratio earlier than planned and urge them
to reduce funding needs.

‘Off Your Books’

Because most buyers of distressed assets fund purchases
with debt, which has become increasingly expensive and difficult
to obtain, banks are financing transactions themselves, even if
it means retaining loans on their balance sheets. That will slow
deleveraging and make more asset sales necessary, analysts say.

“A lot of those asset sales might be dependent on the
banks themselves, the sellers, providing financing to the
buyers,” Raoul Leonard, a London-based RBS analyst covering
southern European banks, said on a conference call with clients
Oct. 20, without referring to any specific deal. “It’ll be
almost false deleveraging going on, but it’s off your book and
you can argue that the risk-weighting changes.”

Loan Quality

Sales of loan portfolios have been sluggish, in part
because banks are reluctant to sell assets at the discounts
sought by private-equity firms such as Apollo, Blackstone and
Colony Capital LLC. Selling at a loss would reduce banks’
capital at a time when regulators are demanding they raise more.

The issue isn’t banks’ high-quality assets, which can be
sold to other lenders, pension funds and insurance companies
without debt financing, said Andrew Jenke, director in KPMG’s
Portfolio Solutions Group in London, who advises buyers and
sellers of loans. Nor is it their poorest-quality assets on
which firms can afford to accept discounts because they have
been written down already, he said.

“The issue is the large pool of medium-quality loans that
are not yet provisioned because there hasn’t been a credit event
triggering an incurred loss,” Jenke said. “There is a big
price gap: too risky for other banks, and not enough cheap
financing for the private-equity buyers. This will make vendor
financing crucial.”

European banks will dispose of less than 100 billion euros
of the more than 500 billion euros of distressed loans and other
impaired assets because they can’t afford to take losses on the
sales, Huw van Steenis, a Morgan Stanley analyst in London,
wrote in a Nov. 13 note. Banks may have to unload some of their
good assets to U.S. or Asian competitors, he said. Van Steenis
estimated banks in Europe may shrink assets by between 1.5
trillion euros and 2.5 trillion euros in two years.

“With very few exceptions, banks will get the best price
for their assets if they provide the financing package
themselves,” Swanson said. “The bank already has the risk on
its books and knows its assets better than any third-party
financier. As a result, it should be in the best position to
provide financing which allows the buyer to put in less equity
and boost the price.”

The issue is more acute for large portfolios of loans, said
Dilip Awtani, managing director in charge of Colony Capital’s
European distressed-debt investments in London.

“The pricing gap between buyers and sellers is still huge,
and one of the ways to close it is vendor financing because the
lending market is contracting and the pockets of capital for
third-party financing are very limited,” Awtani said.

Project Isobel

RBS, which got a 45.5 billion-pound taxpayer bailout in
2008, said in July that New York-based Blackstone would find
outside financing to buy part of a 1.4 billion-pound U.K.
commercial-property loan portfolio codenamed “Project Isobel.”
Blackstone and RBS agreed to set up a vehicle to hold the
assets, which were priced at a 29 percent discount to face
value, said the people with knowledge of the talks who asked not
to be identified because they weren’t authorized to speak.

The world’s largest buyout firm, which will manage the
assets, agreed to buy a 25 percent stake, while RBS will retain
the rest and sell it over time, the Edinburgh-based bank said in
a July 13 statement.

‘Innovative Structure’

Blackstone, seeking to finance the acquisition with 60
percent debt, has struggled to secure outside lending because
credit contracted and became more expensive as Europe’s crisis
worsened, the people said. China’s sovereign-wealth fund, China
Investment Corp., may buy half of Blackstone’s stake, or 12.5
percent, they said.

RBS said in the July statement that the deal was structured
to allow it “to participate in potential future profits of the
fund and from Blackstone’s asset management and market recovery
while at the same time reducing its exposure and risk.”

David Gaffney, a spokesman for the bank, declined to
comment further.

“We think this innovative structure could serve as the
model for future transactions as banks look to dispose of non-core real-estate assets,” Michael Nash, chief investment
officer of Blackstone Real Estate Debt Strategies in New York,
said in the statement. Helen Winning, a spokeswoman for
Blackstone in London, declined to comment.

‘Not Enough Money’

RBS also provided a loan in September to help Patron
Capital Ltd. purchase 24 U.K. hotels the bank seized after
Jarvis Hotels Ltd. defaulted on loans. The lender provided
financing to an RBS venture with Patron that bought the
properties. Because the deal was relatively small, loan terms
were comparable to what was available from other lenders, said
Keith Breslauer, managing director of Patron, a London-based
buyout firm that specializes in real estate and manages about
1.7 billion euros of assets.

For larger transactions, “you need vendor finance to get
deals done,” Breslauer said. “Without it, the deal doesn’t get
done.” Patron is in talks on three deals that will collapse
unless the vendor provides finance, he said, adding “there’s
not enough money out there.”

Richard Thompson, a partner at PricewaterhouseCoopers LLP,
who advises on loan sales in London, said about half the deals
his firm is handling involve vendor financing.

Credit Suisse, Lloyds

Credit Suisse, Switzerland’s second-largest bank, agreed to
sell $2.8 billion in distressed property loans to New York-based
Apollo at a 57 percent discount in December, a person with
knowledge of the deal said at the time. The bank provided a loan
to help fund Apollo’s deal, two people familiar with the
transaction said. Adam Bradbery, a spokesman for Credit Suisse
in London, declined to comment.

Lloyds Banking Group Plc, which received a 20.3 billion-pound government bailout, is considering vendor financing in the
sale of 1 billion pounds of U.K. mortgages, a person with direct
knowledge of the talks said. Ian Kitts, a spokesman for London-based Lloyds, declined to comment.

The National Asset Management Agency, set up to purge Irish
banks of risky property loans, said it will also provide as much
as 70 percent of financing to help sell commercial assets.

Equity Requirements

The use of such funding can reduce the riskiness of the
assets and free up regulatory capital, David Abrams, in charge
of European nonperforming loan investments at Apollo Global
Management in London, said in an interview.

“The risk for the banks changes,” he said. “In a way,
they are turning nonperforming loans into performing loans.”

The buyers need to inject sufficient equity for the banks
providing vendor financing to benefit from a regulatory capital
point of view, said Alexander Greene, managing partner at New
York-based private-equity firm Brookfield Asset Management LLC.

“Ultimately, regulators scrutinize those deals,” Greene
said. “The question is then, will the investors be able to earn
their returns if they overcapitalize?”

Banks must be innovative to sell the “stickiest” of their
assets, said Ian Gordon, an analyst at Evolution Securities Ltd.
in London.

“Banks will be naive if they use vendor finance to
notionally dispose of assets at whatever price the market will
take,” he said. “They could fall in the trap in giving away
the upside without meaningfully reducing the downside.”